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Friday, August 11, 2017

A Tesla 2017 Update: A Disruptive Force and a Debt Puzzle!

These are certainly exciting times for Tesla. The first production version of the Tesla 3 was unveiled on July 28, with few surprises on the details, but plenty of good reviews. Elon Musk was his usual self, alternating between celebrating success and warning investors in the stock that the company was approaching "manufacturing hell", as it ramps up its production schedule to meet its target of producing 10,000 cars a week. It is perhaps to cover the cash burn in manufacturing hell that Tesla also announced that it planned to raise $1.5 billion in a junk bond offering. Investors continued to be unfazed by the negative and lapped up the positive, as the stock price soared to $365 at close of trading on August 9, 2017. With all of this happening, it is time for me to revisit my Tesla valuation, last updated in July 2016, and incorporate, as best as I can, what I have learned about the company since then.

Tesla: The Story Stock

I have been following Tesla for a few years and rather than revisit the entire history, let me go back to just my most recent post on the company in July 2016, where I called Tesla the ultimate story stock. I argued that wide differences between investors on what Tesla is worth can be traced to divergent story lines on the stock. I used the picture below to illustrate the story choices when it comes to Tesla, and how those choices affected the inputs into the valuation.

In that post, I also traced out the effect of story choices on value, by estimating how the numbers vary, depending upon the business, focus and competitive edge that you saw Tesla having in the future:

With my base case story of Tesla being an auto/tech company with revenues pushing towards mass market levels and margins resembling those of tech companies, I estimated a value of about $151 a share for the company and my best case estimate of value was $316.46.

Tesla: Operating Update

If you are invested in or have been following Tesla for the last year, you are certainly aware that the market has blown through my best case scenario, with the stock trading on August 9, at $365 a share, completing a triumphant year in markets:

While Tesla's market cap has caught up with larger and more established auto makers, its production and revenues are a fraction of theirs, leading some to use metrics like enterprise value per car sold to conclude that Tesla is massively over valued. I don't have much faith in these pricing metrics to begin with, but even less so when comparing a company with massive potential to companies that are in decline, as I think many of the conventional auto companies in this table are currently.

As I noted at the start of the post, it has been an eventful year for Tesla, with the completion of the Solar City acquisition, and the Tesla 3 dominating news, and its financial results reflect its changes as a company. In the twelve months ended June 30, 2017, Tesla's revenues hit $10.07 billion, up from $7 billion in its most recent fiscal year, which ended on December 31, 3016; on an annualized basis, that translates into a revenue growth rate of 107%. That positive news, though, has to be offset at least partially with the bad news, which is that the company continues to lose money, reporting an operating loss of $638 million in the most recent 12 months, with R&D expensed, and a loss of $103 million, with capitalized R&D. The growth in the company can be seen by looking at how quickly its operations have scaled up, over the last few years:

Tesla's growth has not just been in the operating numbers but in its influence on the automobile sector. While it was initially dismissed by the other automobile companies as a newcomer that would learn the facts of life in the sector, as it aged, the reverse has occurred. It is the conventional automobile companies that are, slowly but surely, coming to the recognition that Tesla has changed their long-standing business. Volvo, a Swedish automaker not known for its flair, announced recently that all of its cars would be either electric or hybrid by 2019, and Ford's CEO was displaced for not being more future oriented. A little more than a decade after it burst on to the scene, it is a testimonial to Elon Musk that he has started the disruption of one of the most tradition-bound sectors in business.

Tesla: Valuation Update

The production hiccups notwithstanding, the company continues to move towards production of the Tesla 3, with the delivery of the handful to start the process. There is much that needs to be done, but I consider it a good sign that the company sees a manufacturing crunch approaching, since I would be concerned if they were to claim that they could ramp up production from 94,000 to 500,000 cars effortlessly. My updated story for Tesla is close to the story that I was telling in July 2016, with two minor changes. The first is that the production models of the Tesla 3 confirm that the company is capable of delivering a car that can appeal to a much broader market than prior models, putting it on a pathway to higher revenues. My expected revenues for Tesla in ten years are close to $93 billion, a nine-fold increase from last year's revenues and a higher target than the $81 billion that I projected in my July 2016 valuation. Second, the operating margins, while still negative, have become less so in the most recent period, reducing reinvestment needs for funding growth. The free cash flows are still negative for the next seven years, a cash burn that will require about $15.5 billion in new capital infusions over that period. With those changes, the value per share that I estimate is about $192/share, about 20% higher than my $151 estimate a year ago, but well below the current price per share of $365.

As with every Tesla valuation that I have done, I am sure (and I hope) that you will disagree with me, with some finding me way too pessimistic about Tesla's future, and others, much too optimistic. As always, rather than tell me what you think I am getting wrong, I would encourage you to download the spreadsheet and replace my assumption with yours. I think I am being clear eyed about the challenges that Tesla will face along the way and here are the top three:

Can Tesla sell millions of cars? One of Tesla's accomplishments has been exposing the potential of the hybrid/electric car market, even in an era of restrained fuel prices. That is good news for Tesla, but it has also woken up the established automobile companies, as is evidenced by not only the news from Volvo and Ford, but also in increased activity on this front at the other automobile companies. In my valuation, the revenues that I project in 2027 will require Tesla to sell close to 2 million cars, in the face of increased competition.

Can it make millions of cars? Tesla's current production capacity is constrained and there are two production tests that Tesla has to meet. The first is timing, since the Tesla 3 deliveries have been promised for the middle of 2018, and the assembly lines have to be humming by then. The second is cost, since a subtext of the Tesla story, reinforced by hints from Elon Musk, is that the company has found new and innovative ways of scaling up production quickly and at much lower costs than conventional automobile companies.

Can it generate double digit margins? In my valuation, I assume an operating margin of 12% for Tesla, almost double the average of 6.33% for global auto companies. For Tesla to generate this higher margin, it has to be able to keep production costs low at its existing and new assembly plants and to be able to charge a premium price for its automobiles, perhaps because of its brand name.

Tesla has shown a capacity to attract and keep customers and I think it is more than capable of meeting the first challenge, i.e., sell millions of cars, especially since its competition is saddled with legacy costs and image problems. It is the production challenge that is the more daunting one, simply because this has always been Tesla's weakest link. Over the last few years, Tesla has consistently had trouble meeting logistical and delivery targets it has set for itself, and those targets will only get more daunting in the years to come. Furthermore, if its production costs run above expectations, it will be unable to deliver on higher margins. To succeed, Tesla will require vision, focus and operating discipline. With Elon Musk at its helm, the company will never lack vision, but as I argued in my July 2016 post, Mr. Musk may need a chief operating officer at his side to take care of delivery deadlines and supply chains.

Financing Cash Burn: Tesla's Odd Choice

There is much to admire in the Tesla story but there is one aspect of the story that I find puzzling, and if I were an equity investor, troubling. It is the way in which Tesla has chosen to, and continues to, finance itself. Over the last decade, as Tesla has grown, it has needed substantial capital to finance its growth. That is neither surprising nor unexpected, since cash burn is part of the pathway to glory for companies like Tesla. However, Tesla has chosen to fund its growth with large debt issues, as can be seen in the graph below:

That debt load, already high, given Tesla’s operating cash flows is likely to get even bigger if Tesla succeeds in its newest debt issue of $1.5 billion, which it is hoping to place with an interest rate of 5.25%, trying to woo bond buyers with the same pitch of growth and hope that has been so attractive to equity markets. That suggests that those making the pitch either do not understand how bonds work (that bondholders don't get to share much in upside but share fully in the downside) or are convinced that there are enough naive bond buyers out there, who think that interest payments can be made with potential and promise.

But setting aside concerns about bondholders, the debt issuance makes even less sense from Tesla's perspective. Unlike some, I don’t have a kneejerk opposition to the use of debt. In fact, given that the tax code is tilted to benefit debt, it does make sense for many companies to use debt instead of equity. The trade off, though, is a simple one:

If you look at the trade off, you can see quickly that Tesla is singularly unsuited to using debt. It is a company that is not only still losing money but has carried forward losses of close to $4.3 billion, effectively nullifying any tax benefits from debt for the near future (by my estimates, at least seven years). With Elon Musk, the largest stockholder at the company, at the helm, there is no basis for the argument that debt will make managers more disciplined in their investment decisions. While the benefits from debt are low to non-existent, the costs are immense. The company is still young and losing money, and adding a contractual commitment to make interest payments on top of all of the other capital needs that the company has, strikes me as imprudent, with the possibility that one bad year could put its promise at risk. Finally, in a company like Tesla, making large and risky bets in new businesses, the chasm between lenders and equity investors is wide, and lenders will either impose restrictions on the company or price in their fears (as higher interest rates). So, why is Tesla borrowing money? I can think of two reasons and neither reflects well on the finance group at Tesla or the bankers who are providing it with advice.

The Dilution Bogeyman: The first is that the company or its investment bankers are so terrified of dilution, that a stock issue is not even on the table. Once the dilution bogeyman enters the decision process, any increase in share count for a company is viewed as bad, and you will do everything in your power to prevent that from happening, even if it means driving the company into bankruptcy.

Inertia: Auto companies have generally borrowed money to fund assembly plants and the bankers may be reading the capital raising recipe from that same cookbook for Tesla. That is incongruent with Elon Musk’s own story of Tesla as a company that is more technology than automobile and one that plans to change the way the auto business is run.

Tesla’s strengths are vision and potential and while equity investors will accept these as down payments for cash flows in the future, lenders will not and should not. In fact, I cannot think of a better case of a company that is positioned to raise fresh equity to fund growth than Tesla, a company that equity investors love and have shown that love by pushing stock prices to record highs. Issuing shares to fund investment needs will increase the share count at Tesla by about 3-4% (which is what you would expect to see with a $1.5 billion equity issue) but that is a far better choice than borrowing the money and binding yourself to make interest payments. There will be a time and a place for Tesla to borrow money, later in its life cycle, but that time and place is not now. If Tesla is dead set on not raising its share count, there is perhaps one way in which Tesla may be able to eat its cake and have it too, and that is to exploit the dilution bogeyman's blind spot, which is a willingness to overlook potential dilution (from the issuance of convertibles and options). In fact, why not issue long term, really low coupon convertible bonds, very similar to this one from 2014, a bond only in name since almost all of its value came from the conversion option (which is equity with delayed dilution)?

Conclusion

The Tesla story continues to evolve, and there is much in the story that I like. It is changing the automobile business, a feat in itself, and it is starting to deliver on its production promises. The next year may be manufacturing hell, but if the company can make its through that hell and find ways to deliver the tens of thousands of Tesla 3s that it has committed to delivering, it will be well on its way. I still find the stock to be too richly priced, even given its promise and potential, for my liking, but I understand that many of you may disagree. That said, though, I do think that the company's decision to use debt to fund its operations makes no sense, given where it is in the life cycle.

10 comments:

What do you get if you value Tesla as a real option on market leadership in the world of self-driving ride-sharing vehicles powered by energy generated off the rooftop solar panels and stored in mass-produced batteries? A back of the envelope calculation says the company would be worth north of $500B in that world. Is it a plausible story that Mr. Musk has at least a 10% chance of getting there?

Professor Damodaran, While I totally agree with the challenges that you have laid out for Tesla to surmount and I generally agree with your valuation, I think that the debt puzzle might be overlooking the idea of a "Pecking Order." Could it be possible that Elon Musk feels that Tesla common shares are overvalued, but is overcompensating and doesn't want to signal this to the marketplace? I think that his choice to issue debt could provide "false bravado" in the current price.

Might it be that those institutions that already own Tesla stock cannot or will not own any more, making the the market for any secondary offering of equity less liquid resulting in far greater dilution than would otherwise be the case and consequently taking the shine off of the rose?Convertible bond market is not particularly deep to begin with and therefore might be a tough money raise. Not a fan of investment bankers, but there may be some reason for going to HY market.

While I am in general agreement with your point that bondholders should not regard themselves as beneficiaries of the upward Tesla trajectory to any greater extent than its abilities to service debt (if that indeed was your point), it would be interesting to know how other motor company bonds are priced in comparison: Tesla debt may be selling on relative merit as a kind of a hedge 'If Tesla does great, GM bonds will fall. I have some GM bonds - better have some Tesla". In other words the downside fear of traditional motor company prospects combined with the obvious *potential* for Tesla, may lever enough perception to dazzle the debt purchasers.

But in general I agree, seeing that Musk himself has commented on market overexuberance for Tesla stock, that it is most peculiar that more stock is not issued. I say, with some seriousness, perhaps he is keeping it as future collateral for Marsward exploits.

BTW I do enjoy your analyses, particularly that they accommodate within one framework, different narratives or lines or reasoning.

Very interesting and thank you Professor but given that the arguments against debt financing in this situation are pretty obvious it would be interesting to know Tesla's reasoning because the company has certainly considered the issue.

As you may be aware, Seeking Alpha often runs negative analyses about Tesla. One article opined that Elon Musk may have chosen to issue debt because an equity offering would have required disclosures which he was not ready to disclose. I do not know if equity issuance requires a higher level of disclosure than a debt offering, but it is worth considering.

Of all the risk factors you mention, I think "manufacturing hell" is the greatest. I have read a number of comments from businessmen who claim to be experienced in large scale manufacturing who say ramping up to the Model 3 levels will immensely difficult, that high-speed manufacturing requires years of experience to master. Given Tesla's inability to make money manufacturing expensive, low-volume cars, I think skepticism about Tesla's ability to make money on lower-priced, high-volume cars is warranted. I know Elon Musk is brilliant and his accomplishments are astonishing, but making cars is still a gritty, difficult process.

I have read about the huge order backlog for the model 3 -- I have a friend who put down $2,000 for two Model 3's but has no intention of buying one. I think he is hoping to "flip" his place in line. I wonder how many deposit swill fade away?

But with increasing cars on the market will be sufficient after sale services? Will be current customers satisfy with quality of cars and after sale services? Are Tesla cars really as good as everybody think? Tesla has no history. Repair of the car cannot be made from computer.

Do you think that other car makers will not produced comparable cars? Can Mercedes, BMW and other car makers produce comparable or better cars in a few years?

The manufacture of cars becoming financial institution, because a lot of cars are sold for loan or leasing, thats why there will be additional need of financing.

The cars companies become software companies. Is Tesla prepared for that?

Is Tesla one man show?

Are the electric cars really the car which will win the market? Will not other renewable type of cars win the market?

Producers of cars report the best numbers of sold cars in the history. Can it continue to the sky? What happen, when slowdown or recession appear?

Automotive industry is very competitive industry. On the market are better opportunities than Tesla now.

Tesla is trying to redefine a Auto business that is investment intensive unlike Google or FB. Later were more of ideation than the "production"...

Is it worth comparing how it happened in Industrial revolution in last century or is it the case that , it was OK move at slower rate then than today's connected and competitive world ?

What business Tesla is really in ? Are they auto makes or new tech company?.they look more of new tech company with CAR just manifestation of the game....may be they can use their research in other areas like Solar power, battery evolution to charter new teritoires...

Finally charisma of Elon Musk is big part for Tesla...which is hard to value and predict...But companies like Tesla are important part of evolution and hope it does good !!

I'm not sure I agree with the 12% target operating margin. The assumption for this high margin is a combination of premium due to the brand, improvements in manufacturing technology for their cars.

TSLA's ability to command a higher price due to its brand is going to decrease as they continue to push to targeting the mass market. The premium they command will decrease as a result. Cars unlike iPhones are a big expense and consumers are unlikely to pay for increased prices for basic cars. This is especially the case as many other manufacturers begin producing new electric vehicles.

The improvements in manufacturing to the extent that they have a lower manufacturing cost than large car companies like Toyota is unlikely given their lack of patents. They're also up against major auto manufactures that have decades of experience in mass-producing cars. Currently high turnover in employees is also a bad sign for this sector.